Description

Willis Group Holdings (WSH) operates as the smallest of three global Property & Casualty insurance brokers that collectively account for 57% of global brokerage revenue.  Consider that 10% of WSH's premiums come from US employee benefits; another 4% from US construction, as well as significant exposure to developed Europe to boot.  Furthermore, we are entering year 8 of a soft pricing market, unfortunate for a broker that derives 70% of its premiums on a commission basis (vs. fixed fee).  If you knew nothing else but macro and industry-specific issues that have prominently headlined, you may not expect to see this:

In the most recent quarter, WSH reported positive organic premium growth from the UK, Ireland, Spain and Denmark and single-digit growth in continental Europe broadly.

 Rather than myopically focus on short term performance, management has aggressively invested in a sales force that has done a great job acquiring new business and maintaining it (WSH's retention rate of 92% is exceptional for the industry); With its aggressive sales culture, the Company has delivered organic growth above larger peers AOC and MMC, despite their predominantly fixed-fee structures that affords some degree of protection from a soft pricing market relative to WSH.

 WSH is at an important inflection point.  The Company's goal from early '08 of 28% operating margins and $4.00+ EPS by 2010 clearly fell short by a wide margin (actual #s - 23% and $2.75).  Since then, the Company has removed guidance and investors seem fatigued and skeptical of management's bi-annual restructuring initiatives, and their ability to deliver margin expansion.  With the HRH acquisition now complete, the worst of the recession passed, and P&C pricing showing more moderate declines, the Company is better positioned to execute.  2011 is going to be another year of clean-up that will see only modest margin expansion and EPS growth from 2010 before we see acceleration in both measures in 2012 from restructuring initiatives that will take ~$100mn out of future annual costs.

 Valuation

My base case makes the following key assumptions:

 1) WSH uses free cash flow to repay debt through 2Q12, when its total leverage ratio falls to under 2.0x EBITDA, at which point management will use free cash flow to repurchase shares.  WSH recently amended its debt covenants to allow share repurchases as long as the Company's leverage ratio is under 2.75x (it's currently at 2.5x) and suggested considering stock repurchases as leverage approached 2.0x

 2) ~2.5%-3.0% organic growth with pricing a 50bps headwind through 2011 and 2012 and then neutral thereafter.  There are two components to organic growth: net new business and pricing.  All things equal, I prefer pricing, which is unencumbered by incremental investment, to constitute a greater proportion of growth.  I estimate that every 1% of organic growth that comes from pricing rather than net new business generates ~$0.12-$0.15 in annual EPS, all things equal.  

 3) Over 200bps of operating margin expansion to 25%+ in 2012, where it remains for the next several years

 My estimates follow:

 On a P/E basis, applying a 12.7x multiple to 2012 EPS gets me to 12.7 x $3.55 = ~$45 / share (21% upside)

 On a EV/EBITDA basis, applying a 9.0x multiple to 2012 EBITDA gets me to [9.0 x 1,101 - 1,712 (est. 2012 net debt)]/167mn shares (est. 2012 DSO) = ~$49 / share (31% upside)

 While I am using a 2006-present average P/E multiple of 12.7x, this average is weighed down the ~10.5x-ish multiple averaged during '08-'10 when the Company's liquidity profile came under scrutiny, management failed to meet guidance and then "overpaid" for HRH.  Prior to that, the Company commanded a market multiple of 15.0x.  I believe that delivering on accelerated earnings growth in 2012 could be a first step in restoring that multiple.

 Without making a call on the insurance pricing cycle, I will only say the following: 1) We are more than 7 years into the current bear market and the rate of decline has decelerated in recent quarters, from being -4.4% (4Q10), -3.5% (1Q11), and -2.5% (2Q11); 2) even if pricing doesn't turn, you are still earning an 8.5% forward free cash flow yield and not taking any underwriting risk.  When pricing does turn, WSH should be able to leverage prior year sales-force investments. 

If I assume pricing turns to become a 1% tailwind to organic growth in 2012 and 2013, my estimates become:

With the same multiples, pricing produces another ~$3 bucks of additional upside.

Additionally, during the normal course of business, WSH invests client funds held on a fiduciary basis (these are premiums paid by clients that pass through WSH before getting to the insurance carrier).  The Company currently earns ~1.9% on these funds; any additional investment income from higher rates is pure margin, with every 100bps contributing an incremental ~$0.10 to annual EPS.

My downside scenario is that margin expansion remains elusive in 2012 and earnings don't step-function to a higher plateau, in which case 2.5% organic premium growth delivers $3.15 in 2012 EPS.  The earnings multiple contracts to 10x for a share price of $31.50, 16% below current levels.

Management

Chairman and CEO Joe Plumeri, who was hired in 2000 soon after WSH was taken LBO'ed by KKR, owns 2.7% of WSH, and ~$130mn in stock.  Plumeri has not increased his base salary of $1mn since he first joined the firm, and instead has a significant portion of his total compensation tied to adjusted operating margin and organic premium growth targets.  While not critical to the thesis, WSH might also make an attractive buyout candidate; Plumeri could realize a windfall of between $15.4mn and $60mn upon a change in control.  His current employment contract expires July 2013.                                                          

Risks

WSH is pursuing large account business, a deviation from its traditional middle market focus.  According to management, this business will be incremental, leveraging existing expenses.  We shall see. 

Appendix

Catalyst